This Could Spark a China Stock Market Crash in 2016

By Gaurav S. Iyer, IFC Published : September 22, 2015

Just months after China’s stock market crash, financial regulators are warning that the situation is worse than we imagined. Of course, we sensed an economic collapse on the horizon when the People’s Bank of China, or PBOC, devalued the yuan. The depreciation renewed concerns that a slowdown would push the world into a currency war.

President Xi Jingping of China is visiting the White House as cracks appear in his country’s armor. Many observers considered China impenetrable and unassailable; a runaway growth train with no intention of slowing down. That kind of hyperbole is almost always covering a darker truth.

Last year the country began a process of financial liberalisation that left many investors eager to invest. However, the intervening 12 months revealed deep vulnerabilities in the Middle Kingdom. In a matter of weeks, the Shanghai Composite Index lost nearly 30% of its value and has been plagued with volatility ever since.

President Xi is making rounds with U.S. businesses to quell fears of an economic collapse. But that’s a tall order. As he touched down on U.S. soil, the PBOC devalued the yuan yet again. Central banks’ actions speak louder than a president’s words.

The PBOC Currency Devaluation

Currency wars are self-defeating. Sure, cheaper currencies make exports more attractive to foreign buyers, but what happens when everyone tries that strategy? When a central bank lowers the value of its currency in response to another country’s devaluation, no one wins.

There are simply too many moving parts in international finance. If Japan devalues (and it did), then China is forced to respond (which also happened), and South Korea must follow suit (once again, true). Ultimately, it’s a domino effect that leaves all players racing to the bottom.

In anticipation of weak data from the Purchasing Manager’s Index in September, China’s central bank decided it was time for further devaluation. Most media outlets don’t really cover how it happened, but I think it’s important to understand. (Source: Bloomberg, September 21, 2015.)

China still sets a target rate for their currency as it trades in Shanghai. The currency is allowed to fluctuate within two percent of that target. On September 21st, the PBOC cut its rate by 0.07%, prompting a 0.11% intraday fall in the yuan. This was less about market forces and more about a strategic devaluation.

Under normal circumstances I can’t imagine that President Xi would have green-lighted a currency devaluation while he’s negotiating with President Obama. China’s making a play to get the yuan booked as global reserve currency, but the blatant depreciation undermines their entire argument.

President Xi Soothes Fears Over Stock Market Crash

President Xi is working hard to dispel concerns that China is on the verge of economic collapse. He gave an interview to TheWall Street Journal which touched on a range of sensitive issues.

“China’s economic growth is still one of the fastest in the world,” said President Xi. “In the first half of the year, the Chinese economy grew by 7%, which is hard-won considering the intricacy and changeable nature of the overall global economy.” (Source: The Wall Street Journal, September 22, 2015.)

Mr. Jinping’s words stand in stark contrast to the actions of his country. He says the economy is growing at seven percent, but doesn’t really explain why the central bank continues to devalue the yuan. He knows, as does everyone else, that manufacturing output has fallen for the last six months and September will seal the trend.

These are the facts. And although they are politically ill-timed for President Xi, investors should take heed.